No Mr. Modi, Tax Devolution To States Won’t Make Centre Much Poorer

In his letter to Chief Ministers announcing his government’s decision to accept the recommendations of the 14th Finance Commission, Prime Minister Narendra Modi writes:

The 14th FC has recommended a record increase of 10% in the devolution of the divisible pool of resources to states. This compares with the marginal increases made by previous Finance Commissions. The total devolution to states in 2015-16 will be significantly higher than in 2014-15. This naturally leaves far less money with the Central Government. However, we have taken the recommendations of the 14th FC in a positive spirit as they strengthen your hand in designing and implementing schemes as per your priorities and needs. (italics added)

While it is true that the Finance Commission has recommended a 10% increase in the share of the states in the divisible pool, it is not true that the award leaves ‘far less money with the Central Government’ if the Centre’s finances are considered as a whole, i.e., including money not in the divisible pool. I’ve summarised the recommendations of the Finance Commission in the table below (all numbers in rupees crore).

While Mr. Modi and his government have highlighted the fact that tax devolution to states has increased as a percentage of the divisible pool (purposely omitted from the above table) from 32% to 42% in the award, one cannot conclude from it that the Centre is left with ‘far less money’. One needs to look at aggregate transfers to states as a percentage of the gross revenue receipts for it. That is what I plot in the following chart, together with the percent-wise break-up of the transfers in terms of tax devolution and grants (from the data in the above table).

Clearly, the aggregate transfers to states (middle curve) indicated by the FC-XIV remain relatively flat before and after the 14th Finance Commission (i.e., going from 2014-15 to 2015-16 and later). In fact, the report clearly states in Section 2.28 that:

We have noted that aggregate transfers accounted for around 50 per cent of the gross revenue receipts of the Union. Keeping in view the Union Government’s expenditure responsibilities, and the need for fiscal adjustment at the Union level, we do not see the scope for increasing the transfers beyond the current level.

Historically, the actual aggregate transfers have tended to lie between 44.7% and 53.7% as a percentage of the gross revenue receipts (as explained in Section 12.6), and that is not changing. The 10% jump from 32% to 42% happening at one go in the first year of implementation, which everyone including Mr. Modi is talking about, appears when one takes only the tax devolution portion of the aggregate transfers and divides it by the divisible pool. This is not to be seen in the above chart which presents the whole picture.

In fact, this 10% jump being talked about everywhere is misleading because it masks the actual expected increase in the aggregate transfers to the states as a percentage of total money with the Centre, which is far more modest (middle curve, 47.54% in 2014-15 to 48.33% in 2015-16). The major increase recommended by FC-XIV is only in the tax devolution portion of these transfers (upper curve, 50.98% to 66.93% in 2015-16), but the grants portion is recommended to be reduced almost equally (lower curve, 49.02% to 33.07% in 2015-16).

Thus, although it helps lend Mr. Modi’s political party the hue of martyrdom, it is not correct to say that the Centre is left with ‘far less money’ because of FC-XIV. The confusion here is because only the tax devolution part of the overall transfers to the states are highlighted, that too expressed as a percentage of something other than the total money in the Centre’s kitty.

Note, however, that Mr. Modi and his government are right in their communication that the states have more of a free hand when it comes to using their funds now. This is because of the recommended and welcome shift of funds to tax devolution from grants, which essentially require state governments to do what the Centre wants them to do.